Optimal consumption and asset allocation with unknown income growth

Recent empirical evidence supports the view that the income process has an individual-specific growth rate component [Baker, M., 1997. Growth-rate heterogeneity and the covariance structure of life-cycle earnings. Journal of Labor Economics 15, 338–375; Guvenen, F., 2007b. Learning your earning: Are labor income shocks really very persistent? American Economic Review 97, 687–712; Huggett, M., Ventura, G., Yaron, A., 2007. Sources of life-cycle inequality. Working paper, University of Pennsylvania]. Moreover, the individual-specific growth component may be stochastic. Motivated by these empirical observations, I study an individual's optimal consumption–saving and portfolio choice problem when he does not observe his income growth. As in standard income fluctuation problems, the individual cannot fully insure himself against income shocks. In addition to the standard income-risk-induced precautionary saving demand, the individual also has learning-induced precautionary saving demand, which is greater when belief is more uncertain. With constant unobserved income growth, changes in belief are not predictable. However, with stationary stochastic income growth, belief is no longer a martingale. Mean reversion of belief reduces hedging demand on average and in turn mitigates the impact of estimation risk on consumption–saving and portfolio decisions.